What’s Causing the GameStop Stock Trading Frenzy?
You may have seen headlines this week about a sudden jump in stock prices of dying companies like GameStop ( up 400% ) and AMC ( up 375% ). What about Blockbuster? Yes, they still exist in the form of cheap stocks – and they too are up over 2000% from the previous period this week. What’s happening?
Rise of the retail investor
In traditional value investing, you find an undervalued company, buy stocks when they are cheap, and then make money when they go up. In the case of these shares, the valuation does not really matter. After all, no one expects much from GameStop – the brick-and-mortar chain that is battling the pandemic with an outdated business model – let alone a mummified Blockbuster shell.
So why isn’t the performance of these companies’ stocks driven by their fundamentals? Because what we’re really dealing with is a short-selling battle between large hedge funds and increasingly influential and organized retail traders who have grown in influence through commission-free deals, individual investor apps like Robinhood, and online forums including the popular , raucous subreddit r / wallstreetbets (self-billing: “4chan found Bloomberg terminal”).
Short Selling Bets Series
To understand what’s going on, you need to know how short selling works. Short selling, commonly used by large institutional investors, involves a short-term bet that the company’s stock will go down. Basically, these investors borrow shares of that company from a broker-dealer, immediately sell them in the market, and then buy them back when the price falls, after which they pocket the difference and return the shares to the broker-dealer. This is a risky investment as the stock must eventually be returned to the broker-dealer and there is no guarantee that the stock price will ever fall.
The point is that these institutional investors got greedy with their short selling as they sold over 100% of their shares outstanding for these companies ( 139% in the case of GameStop). This means that investors have placed more shares than actually existed, which is quite unusual. This caught the attention of retail investors, giving them the opportunity to both make money and make some money from large hedge funds.
The squeeze for retail investors
So what happens when a group of hobbyist investors invests in short stocks, pushing up their price? Short sellers lose a lot of money. Worse, the original broker-dealer may demand an immediate return of their shares as part of a margin call , forcing the short seller to buy back the shares they have already sold, even if they are now worth much more than they sold them. And when they do, the stock price continues to rise – part of a feedback loop known as the ” short squeeze.” “
In what has been dubbed “nerd revenge,” individual investors do make money from these short squeezes, and it just caught hedge fund managers by surprise. As with short selling, getting money under the squeeze requires timing and discipline as the investor will want to sell when the buyback frenzy of short sellers peaks. Another strategy, approved by Reddit, was to call brokers and insist that they not lend out shares for sale – a standard right of customers – thereby further increasing the value of the shares.
In theory, speculation ends when enough short sellers finally cut their losses and dump stocks – but then again, in theory, Reddit could hold a memstock like GameStop for as long as they want.
It’s illegal?
According to Bloomberg , the SEC is likely to “scrutinize” the trade, and the Treasury Department says it is “monitoring” the situation. However, accusations of market manipulation usually require some evidence that investors deliberately spread false information in order to get other traders to buy or sell stocks. In this case, you can argue that Redditors’ head-spinning YOLO motives were actually pretty transparent.
As James Cox, a professor at Duke University School of Law, told Bloomberg:
“This is a coercion nightmare for the SEC. The question is, where does the manipulation start and when does trading start on the basis of your own guesses and publicizing your guesses? “
Typically, successful enforcement usually hinges on how the SEC shows that investors are knowingly spreading false information in order to get other traders to buy or sell stocks.
Bloomberg’s Matt Levine points out that the SEC will have to take unprecedented action to deal with such a case here – if they take any action at all.
Will this affect your investment?
All investments in the stock market carry a certain amount of risk, and stock volatility is part of that risk. However, it is not yet clear how these actions by retail investors affect traditional long-term value investors. A more immediate problem could be that FOMO retail investors will take risky bets and lose money that they cannot afford to part with. The point is that individual investors must be fully aware of the risks they are taking, especially with respect to any investment phenomenon described by words such as “madness” and “insanity.” And if you’re itching to use an investment app like Robinhood, read this CNBC post on risks first .